The Reflation Trade is ON!

11 OCTOBER 2019

The Reflation Trade is ON!

It's been over a month since I wrote about the reflation trade in the September long short report. This was ahead of the tax cut announcements that followed and was based purely on the trend in monetary policy across the world. The fiscal stimulus then comes as a positive surprise and also a parallel trend that might emerge in the global landscape to address the slowing growth specifically coming from the manufacturing and automobile sectors. The risk is that it will spread to the services sector and becoming a bigger problem, unless addressed.

What made me preempt the situation in the first week of September was the confluence of extreme negative sentiment indicators that had come together, they were not just reflected in the financial data, but the super short positions among foreign institutional investors and also by the media and the narrative that was coming out of the Indian corporate sector. Anyone and everybody that was speaking was still negative about the impact of the slowing production/sales on earnings and growth in general. This during the first year of a new government that was hard pressed to address issues from its previous regime, and central banks that were on their toes, both pushing hard to change the scenario was an indication that things could turn for the better.

The surprise, then, is not the announcement of the fiscal package in the form of tax cuts, but that a month later, the market is still struggling to take off on the way up. In the first week of September, India was lagging behind most Asian and US markets however, a correction in the latter part of the month has brought most of these markets to the same place. They are all awaiting some kind of announcement out of the US and China over this weekend in the form of a trade deal so that we can get over the negative sentiment that it has created globally. The reason that we continue to see extreme pessimism in India and I continue to get multiple messages, especially on social media telling me that the markets are headed towards the 10,000, marks a sign of the kind of sentiment that lies on the street. I'm not saying that any of the analysis is wrong but when posed with a choice of alternate paths the decision has to be based on what other indicators are telling us. Sentiment last month was already where major market bottoms occured in the past. There is too much risk now in the view that Nifty will go below 10600 this year. I am then hinting that 18 months of selling in stocks, some of which have lost up to 90% has already taken place. The issues in the non-banking financial sector were earlier not accepted by a majority, growth slowing was not considered fact by either the previous government or research analysts across the financial services industry. All that has come to pass. Now that everyone has accepted that growth slowed and that we have faced financial stress in the system since the announcement of the IL&FS fallout the worst appears discounted in prices. If after all this Nifty is still at 11000 then the pain has been absorbed. The crash in the markets in terms of what stocks have done not just in the non-banking sector but also in the automobile sector, the nifty continues to hover above the 11,000 mark multiple attempts to break below 10,600 have failed. This is just a reality that you have to accept.

If all is known and all has been accepted in the markets have already discounted it. The expectation that existed a couple of months ago that large caps would give up and join the mid-caps on the way down might then have come to pass as large caps too have seen a correction, but not as steep as that in the MidCap space. Given all the problems that we have faced if a decline had to materialise or contagion had to show up, then the discounting mechanism of the market has ensured that we are now set up to move from an extremely oversold condition back on the way up for months to come till we again hit another extreme in terms of bullish sentiment. The real pain of the last month has been the continued flow of bad news even after the tax cuts. Apart from the announcement of additional taxes on China by the US we have been bombarded by news of a fallout from Yes Bank IndusInd bank the selling of pledged shares in Yes Bank and ZEE, the closure of PMC Bank in Mumbai, the downgrade of GDP estimates for the coming year by the RBI and credit rating agencies, and the India Bulls housing finance fallout in terms of its merger with Lakshmi Vilas Bank that were supposed to help it fund its future growth plans. The impact of these news flows has been specifically harsh on the banking sector and bank nifty has repeatedly attempted to hit its support levels and test them over and over again. Despite that the last one month we have also seen higher bottoms in the nifty and bank nifty and that pattern is what keeps hope alive that we will move from discounting the negative news flow to consider the impact on growth in the quarters ahead.

And this brings us to 'The Reflation Trade' that is no more just a domestic factor, but a global event in the making. The US Federal reserve has bought more than $175 billion worth of US Treasuries in less than a month and last light in a address that was telecast Jeremy Powell has mentioned that the US will quickly move towards the expansion of its balance sheet, even though they will not call it quantitative easing[QE}] This will be through the purchase of bills from the market to support liquidity needs that have cropped up, the direct impact of this has been in pushing the dollar down. A weak dollar is the first sign of a reflation trade that spills over into commodity markets and emerging markets. Typically, when the dollar is falling, then commodity prices, and Emerging Markets prices and tend to go up in value as the excess liquidity created moves away from the US towards other markets to hide from a weak dollar, the simultaneous stimulation that various other economies are conducting by cutting interest rates or, as in the case of India, also fiscal stimulus, is adding to the attraction for US dollars to diversify into these markets in expectation of better returns. In short other markets have become more attractive because of the fiscal and monetary stimulation. So thinking Macro, the US is back to lowering rates and buying bonds creating fresh liquidity. All other markets are following suit. But now from US being the cleanest shirt in the neighbourhood we are now going to talk about the dollar being the dirtiest currency floating, as dollar printed will outdo the quantities of other currencies being created.

So First, watch what the dollar is doing, the dollar's resumption of its bear market in a 3rd wave down will impact the CRB index reflecting in rising commodity prices. Base metals and crude oil prices are likely to move up in the months ahead. The direct impact of that would be energy stocks and metal stocks moving up in tandem. Precious metals that have already rallied as a safe haven trade along with the dollar during 2019 might actually pull back a bit in the near term. In other words, the reflation trade might not directly go towards precious metals in the months ahead, because of their safe haven status in a risk on trade would lead to a move out of precious metals and the dollar into other asset classes in the short-term, the excessive long positions in gold futures as reflected in the commitment of traders report is also a reason to believe that there will be downward pressure on gold prices. The seasonality is also typically bearish between September and December for Gold. My sense is that precious metals will join the reflation trade in terms of rising commodity prices after December 2019.

World markets from the Dow to the Nifty that have continued to hold up against negative news and the slowing in economic growth and the manufacturing sector have done so only in the anticipation of the coming reflation trade that many countries have been announcing. That trade may be now in its final stages of being tied up into a clear trend for the months ahead. If there was a single indicator you needed to watch for this watch for the falling dollar.

Indian Equities

The Nifty has had a month long period of pain because multiple attempts to move higher were faced with a push back. In Sept I highlighted 2 EW alternates the first was a large retracement of the May-Aug decline, in wave 2. That is now achieved in terms of levels and I have put on the back burner the wave 5 ending alternate for now. The second case was that we are forming an ending diagonal and wave E goes up to 12300 as shown below. That is the next best case scenario on cards.

Given the 18 month bear market in stocks and potential for a bottom in Midcap and Small cap indices, I have gone back to considering the next bullish wave count based o my 2014 observations. This in a way is my primary wave count in the daily and weekly updates. I discussed it too. The Reflation trade is not a one month affair that can end in wave E as above. Wave 1 down in the dollar index was a year long affair. Wave 3 down could easily be as long. The sentiment will also have to do a complete U turn. We have to now go to the point where the bubbles that were inflated are reflated again to new hieghts. Optimism will reach new hieghts. Wave 5 of a multi year advance will end in Euphoria and over valuation. On the chart below the trendline of the highs goes to 13000, and a parallel channel to 15500. Now it may sound insane but we keep it there till fresh sell signals develop. Wave 3 in this chart is almost equal to wave 1 in Nifty but it is shorter than wave 1 in most alternate indices like the Nifty 500. So I think wave 5 will be shorter and might stick to the channels, else 5=1 would be over 18000. That I think is unlikely.

The chart below is a historical Nifty/Sensex valuation chart based on the P/E ratio from Vivek Patils weekly update. The 1992 print was almost 45 for the Sensex but has been lowered after BSE changed some wrong data. Still it reads 38. After that most tops in the market were at levels of 32 or lower. So we became used to the idea that we top out near 30. This was particularly true for Nifty. But that is not a rule. Markets often go for the unexpected and if we take off from the elevated 26 times historical earnings valuation we can end up at new heights above 32 again. Research analysts may argue that we are at 16-17 times forward consolidated earnings. Well now that tax breaks and rate cuts will allow them to be right about some forward earnings it is possible that these numbers turn out to be right. But I will stick to historical as a measure for where we are sentimentally as there is little room to manuevere in reported data. In short the reflation of asset prices can push Indian equities 23-40% higher on P/E ratios toward previous records that were achieved.

While I do expect a broad based rally to develop, it should not mean going back to junk. The market has destroyed weak players and they will be left by the wayside. It is the survivors that will make it back. The Nifty as discussed above is going to see a truncated 5th wave but that is still a lot in size. Chase momentum but do not waste time bottom fishing the old wine in a new bottle. I will be watching this BSE Allcap index on an arithmetic scale for wave 5 up to go to the top end of the channel.

So when it comes to Midcap indices I have to rework the wave counts to fit the above scenarios. What we can see on this next chart however is that we have had a very deep cut in the underperformance cycle of Midcaps relateive to large caps. While time equality has not been achieved prices have fallen steeply. This was also seen into 2007 from where markets spiked once more into the 2008 top. We are now in the spike phase, where large caps go up a lot that Midcaps just catch a bid in sympathy, and later they both come down together again. So there will be some fireworks.

The BSE Small cap index shows one possible way to mark this market. Not perfect as the internal waves of wave 3 are not clear perfect 5 waves without adjustment. Maybe later I will mark it as A-B-C-D-E of a 5th wave at supercycle degree. What we will get now though is an attempt in wave 5/E up to the wave 3 high, it would be lucky to see if we can head toward the top trendline on this chart. Note this is not a parallel channel.

Bank nifty does not give a very clear picture and needs more thinking but this is the best I can fit with the above scenarios. Different from that seen on other charts 2010-2016 is probably a running triangle in wave 4. And then wave 5 goes on. It is subdividing till the channel lines break. Then we just completed wave IV of 5 as a running flat. Now wave V of 5 up next can go to near 38000, near the top end of its small channel. This chart might have to be reviewed for more iterations.

Sentiment on the street.

Out of all the Sentiment indicators that I looked at in Sept none are at the extreme ends cause they have bounced out of it, but they remain nearer the lower end of their ranges. For example in this first chart, FIIs are not record short but are still short on the market. Most of the tops since 2016 FIIs were on the long side before a top. The last record long position was in the months before the demonitisation top.

The 20 day A/D ratio has pulled back with stocks to the first red line. This line often holds during corrections of an up trend. So I think we are there and should start seeing breadth improve from here into Diwali.

The Volume Put/Call ratio of the medium term trend remains elevated even though it has started to cool down a bit. What was interesting is the bullish divergence between the two bottoms. The market was at a higher high in 2019 v/s 2018 a year ago, but the indicator shown below was at a higher high at the higher bottom. So more people were bearish and trading puts last month than a year ago in Oct-Dec'18. I would like this indicator to now go back to the lower end of its range before another major top occurs.

Sounding  Global

Let me start with the Global index of ADRs as a guiding light. Long term readers know that I was sounding alarm bells when we hit the top trendline in march of 2018. Many world markets topped even though India held its own till August of that year. So we were bearish at the top end of the triangle and now as the lower trendline has been reached and is holding it is time to consider bullish alternates. Wave C down from the top end should have broken already so that might not be the case. Two things are possible. This triangle as shown below is a bullish running triangle in wave 4 OR this is a wedge and the next move to a new high is wave E of the wedge back to the top line of the last two highs. We will have a lot of time to figure out and post the right count. but are bullish from a 6-12 month perspective unless the lower line breaks. Weekly momentum is back in buy mode and if world markets hold up for October then monthly momentum could also cross over to the buy side.

With that we go to the Dow or DJIA, where you have seen me mark a triangle recently. Prices have taken support on the lower end of the triangle and started higher. What is the wave count. This triangle cannot be wave 2, and you will only find the explanation in the chapter on complex corrections where wave Y or Z ends in a triangle. The chart below is marked as W-X-Y in wave 4 for the Dow. Instead of a topping pattern we have a complex consolidation that is rare but text book. I could not recognise these till it occurred in gold in 2009.

So the implications are that we are starting wave 5 from the higher bottom in Y and will head to all time highs to the top end of the long term channels again. The S&P shows a good channel, and in wave 5 I cannot rule out a throw over above the 5th. The top line goes to 3500.

Here is a chart of Gold from 2009 onward showing how gold formed a complex 4th wave back then, similar to what the Dow is doing, and how it broke out to new highs from there. This is the first time I recognised this pattern in real time.

So where is gold today? Early stages of a new bull market. It is now correcting in wave 2 down. Wave 2 down could continue for months into the seasonal December bottom again. The recent top involved record Long positions by managed money accounts that need to unwind before wave 3 up can start. This is similar to what happened in 2016. So while the reflation trade picks up ground in base metals and Oil Gold and Silver might head lower for a while, then join in later with a 3rd wave.

In the really big picture we are in wave 3 of 3 circle long term. Where 3=1 for this third wave is itself at 8000. Long way to go. We can continue to map the long term channel for years as it develops.

Similarly the gold bugs index [HUI] of gold mining stocks is now in wave 2 of a 3rd wave. See how wave 2 ended in wave Z at a higher high, we call that a truncation. Unusual but it happened. Now we are in a new bull run for this sector apart from the near term correction that has come first.

The Big trade

With that I come to what the reflation trade is going to look like on charts. And that starts with the dollar. Tonight is a big night as far as this is concerned as the dollar is breaking down sharply below the wedge line that it closed below last night. Let us start with this chart I published 3 years ago. I marked the 2016 top as the end to the 9 year bull run in the dollar. The dollar has seen repeated cycles of 9 and 7 years. With that I considered the start of a 7 year bear market in the dollar index. 2017 was a big decline in the dollar that saw commodities rally and reflate. That ended in 2018 with a wave 2 or B rally up. Now we are starting a 3rd wave down that could be larger than the first and maybe goes back to new lows in the years to come. You have to be positioned for what ever this means.

When it comes to the wave count the first decline in 2017 was small, therefore I do not know if that was wave 1 of A or wave A itself. We leave that open. Now a third wave has started 3=1 goes to 83 and 161.8% of wave 1 is at 76.22. One of the two will come in the next one year and that is what concerns us immediately.

What is the immediate fallout of a falling dollar. Frist precious metals have already anticipated this is the risk off safe haven buying last year. Now it is time for energy metals and agro commodities to play catch up big time. In the Sept report I was considering the triangle in the CRB index as wave B and wave C up to follow to a retracement. But today here is the next best alternate. The triangle is wave Z of a bear market and the worst is over for resources. Then we get a bull market in the resources market. A move to the falling trendline is a given but why cant we breakout of this into a new bull run? We can and should be prepared for it. We can work around it if it does not happen. But the sheer size of the coming bear market in the dollar means something larger has to happen.

This is the most basic form of what we call the reflation trade as reflected in commodities prices that results in some inflation. Back from what was nearly a deflation. The immediate effect of that is that most fund managers put on a risk on trade. What is that you ask? It is the trade off between owning equities v/s bonds. In 2016 when Donald trump was elected we got the first major risk on trade. Bonds fell interest rates went up and on the other side stocks went up. In 2018 and 2019 we have seen that trade unwind. Now we are ready for another risk on trade. Stocks are going to go up and bonds down, that means interest rates go up. That is only logical, when commodities prices drive inflation, interest rates go up. Stocks will not mind that in the short term, Bond yields pose a problem only at inflection points and that maybe some time away. Till then we are going to blow one more bubble into stocks. But I think the big moves will be in the resources stocks. Here too tonight bond yields have taken off in minor wave iii up as I write ahead of US + China trade talks in anticipation of what is coming. But apart from trade talks the risk on trade was signalled by Central banks committing to expansionary monetary policy all over again in the last few months to avert slowing economic growth.

To give you perspective of how far the CRB index can go think about this. Gold at an all time high will not be the only attraction. Commodities like Copper have formed a triangle typically seen in a 4th wave. If true wave E just ended at 61.8% in the triangle. the we start long term wave 5 that will end up at new all time highs for copper prices. Did I say All time highs for Copper prices? Yes. Let me also throw something out of the text books that we will watchout for, wave 5 in commodities can often be the largest because they are backed by fear. Not so in stocks where we project 5=1 as wave 3 ends up being larger in many cases. So expect prices to overshoot expectations

With that let me then put out the BSE Metals index again. If the above is true then so is this. We formed a triangle between 2010-2019, and are now set to take off in a 5th wave to new highs. Without putting a number on it I would expect it to be exponential.

All of this in the end points to some degree of inflation and higher interest rates. So the US 30 year bond yields will eventually rise to above 3.5% that we saw last time. The push level will be the top trendline near 3.30% though. 

While all that happens how Indian interest rates behave is another story. The RBI has a few more rate cuts left before it maybe forced by the market to start raising again. In fact the most recent rate cut had a zero impact on bond yields because of the new costs arising from the tax breaks. A global bond yield surge will become a second pressure point. Again it may not matter right away if we get a pop in growth in between. But not at 7% or 8% but above that it is going to matter. The chart below still suggest a possible surge at some point back to 10% in bond yields. At that time, or some where along the way the reflation bubble will have popped. Till then let us contend by calling it a risk off trade.

The Dice is set rolling tonight and if everything remains equal the trends highlighted in this report are imminent right away. The chart of the daily DXY spot NYSE below shows a clear breakdown from a wedge indicating that the trend has reversed. This has been followed by a  jump in stock prices, bond yields and commodities prices. This is going to be a multi month trend that will end only when yields surpass an inflection point and where inflation either becomes stagflation or hyperinflation. 

In the near term however the flow of liquidity into asset markets means that money needs to find a home. It will chose between expensive equities and cheaper commodities and clearly steer away from an expansionary dollar. This may continue till bond markets fall too far and the risk on trade starts to mean revert all over again. Central banks have your back except this time we will have gone too far into the bubble to come back softly. We are going into a hyper bubble not knowing perfectly how it will end because too much money is sloshing around. We do know, however, where the immediate trades are and money can be made in this environment. By participating in the final blow off bubble phase.

CONCLUSIONS

The reflation trade started last night and is now accelerating. This is bullish for equities and commodities and EM currencies. The months ahead are about a bull run in commodities and resources stocks. Those moves will be exponential while they last. Nifty 13000 or 15500 we will soon find out. We could get 6-12 months of this move because the dollar bear market is not a one day event and is very bullish for Emerging markets. It could last all year round. All markets will count 5 waves up before they are complete and so we should get a sign before the next turn in the markets. Till then ride it with the horns. Gold and Silver will also participate in the reflation trade but after December on seasonality. Interest rates as reflected in bond yields are at the lowest or get one last knee jerk lower in India then go up for months. US yields have already bottomed.